Stocks Are a Good Investment Now; Here's Why

There are lots of ways to try to figure out if the stock market is over or undervalued. Market timing -- trying to get out at the top and in at the bottom -- is a fool's game. But that doesn't mean we can't try to take the general temperature of the market from time to time to inform our decision making.

Back in April, fellow Fool Jordan DiPietro wrote an excellent piece on why he thought the stock market might be overvalued by 44%. Since then the S&P 500 (INDEX: ^GSPC) is down about 14%.

Given that there's still a long way to reach Jordan's prediction, you'd think that I'd shy away from buying stocks now. But that's not the case at all. In fact, I now think the market is slightly undervalued. Read all the way to the end, and I'll offer you access to a report featuring five excellent stocks for this undervalued market.

But first, back to the macro picture...

Shiller indexAs Jordan pointed out in his piece, "Yale economist Robert Shiller successfully called out the tech bubble in 2000 and forecast the housing bust in 2006. Now he's making another a dire prediction: The stock market could be overheated, and it's expensive relative to its historical valuations."

Usually, investors use the price-to-earnings ratio of the broader market as a barometer of how expensive stocks are. Currently, the S&P 500 is trading at 14 times earnings over the past 12 months, and the Dow Jones Industrial (INDEX: ^DJI) is at 12. Given that averages are usually around 15 or 16, this seems great.

Not according to Shiller. Instead of just using the past 12 months to measure P/E, Shiller created a measure he dubbed the cyclically adjusted price-to-earnings ratio. In essence, CAPE takes into account the inflation-adjusted earnings of the past 10 years in order to smooth out the cyclicality of the market. Here's what the market's CAPE has looked like since 1881.

If you take all this data and compute it, the average CAPE over the past 130 years comes out to 16.41. With today's CAPE sitting at 19.3, the market still looks overheated to a tune of 17%. So why, looking at this data, do I still believe now is the time to buy stocks?

Psych 101It all has to do with investor psychology. Back when the market was in its infancy, all the way up to the mid-1950s, stocks were judged far more on their dividend payouts than on their future earnings potential.

If you think about the businesses that were around then -- stalwarts in railroads, oil, and manufacturing -- this makes sense. Once infrastructure was built out, there were significant barriers to entry, and companies could dominate their industries for decades while throwing off copious amounts of cash. Shareholders -- who actually owned the companies -- demanded that cash, and received hefty dividend payouts as a result.

But take a look below at the historical dividend payout of the market, and you'll see something started happening around the mid-1950s that took payouts much further down.

I believe what happened was simple: Technology started changing the game. After World War II, a wave of developments swept across America's landscape.

New industries were formed, and companies decided to keep the cash they had on hand for future development instead of offering huge dividend payouts. Likewise, investors were willing to pay a hefty premium for future earnings potential, something they had been unwilling to do in the past.

Though not every company fulfilled its potential -- and investors in those companies lost even more for paying a heftier premium -- those companies that do fire on all cylinders reward investors for their investments.

Because CAPE takes the trailing 10 years into account, I went back and figured out what the mean CAPE has been since 1965 (10 years after the mid-'50s shift). The result: An average CAPE of 19.57. With today's reading at 18.58, that means the market is slightly undervalued -- by about 5% to be exact.

Go where the deals areTaking this new metric into consideration, I went looking for stocks in the S&P 500 that offered value to long-term investors. By no means should you load up on any one company, but if you've been sitting on the sidelines while the stock market slides, here are some companies to consider getting your feet wet in.

I went looking for companies with P/Es less than 10, price-to-earnings growth less than one, and that are expected to grow earnings by at least 15% over the next year. Here's what I found:

These options represent attractively priced technology companies (Micron and AMD), an insurance company (Hartford) that -- along with the rest of its industry -- has been hit hard as of late, an interesting real estate play that owns the rights to forests and their lumber (Weyerhaeuser) that has fallen about 40% in the past six months, and a leading solar company whose industry has dropped off a cliff lately.

By no means am I suggesting that you should go out and buy these stocks right away. These are just my thoughts, based on a very basic screen that I ran on S&P 500 companies. You should always do your own research before buying.

A group of our top analysts hand-picked these stocks. The Motley Fool has so much faith in these stocks, that we've actually bought them for our company's portfolio. You can get the report today, absolutely free!

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Until we see how Europe will turn out, or at elast until they get the proper mechanisms in place even, committing new money is crazy. Today aand yesterday we are having a monster truck rally because of Dexia. But if you look closely, the financials are not participating. We're not going anywhere without them.

As Mohamed El-Erian pointed out in a piece earlier this week, even if you believe stocks are cheaply valued, doesn't mean they can't get a whole lot cheaper!

I would disagree with the assessment that the market is undervalued. Although I do tend to agree that the market runs in cycles, I still think there is a lot of downside ahead and we seem to be have smaller highs and bigger lows. That tells me there is a lot of uncertainty. And as a previous poster stated:

The EU has a lot of problems ahead dealing with the likely default of Greece and the other PIGGS. That will also drag down the US. And to top it off, the US debt is not very likely to decline so we just might see a default here as well. As a matter of fact, I don't really see how the US can avoid a default at some point. There is way too much unfunded liabilities and the on-budget isn't looking too great either. Just think what a rise in interest on government debt to say 12% would do to the deficit.

The thing with Europe is everything takes them so incredibly long that the risk of Eurorecession may be here for a while. I don't expect a resolution on the Greece debt situation before end of the calendar year. In the meantime, there are decent investment opportunities to be pursued.

I am an investor, not a trader. In my humble opinion, right now, this is a trader market, and, as an investor I am going to sty away from it until Europe, China and the USA will offer a clearer picture of where they are all going. Let us not forget China, the murkiest economy on earth, and one that may surprise us very badly when its burocrats will not be able to hide the truth any longer. Can anybody see a bubble or two bursting pretty soon?

As an investor I am a total newbie, but I'm looking at solid companies that have been around a long time, have good ROIC to P/E numbers, and are priced at near historic lows. I'm also looking very long term, like 10 to 20 years. But most importantly, I'm not betting more than I can afford to lose. One example would be Microsoft, who's been getting their lunch eaten for over a decade but has earnings that are virtually the same as Apple. I would welcome any feedback from the more experienced investors out there (who would be virtually anyone)!

For this particular article, I used finviz.com. One thing that is the same: an assumption of huge growth (80% +) over the next year.

@mdalcant-

I completely understand and sympathize with that assessment. While things may head down for a while, I'll be the devil's advocate and throw in there that the best deals always come from when pessimism is highest.

@xetn-

As I stated above, I completely agree that the EU represents a level of risk that's alarming. On a purely technical basis, though, the US really CAN'T default by definition. All of the money they owe is in US dollars. They can simply print more money to meet their obligations. The bigger concern--since this is an option--would be inflation.

@mikecart1-

Agreed, and this is something I kept in the back of my head while doing this. I actually started tracking this after reading a book (can't remember the title) about the history of the stock market and seeing how enormous the average yields were and how tiny the P/Es were.

Stocks are a good buy unless something goes terribly wrong in Europe, which, though unlikely, is possible. The planned levering up of European debt is extremely dangerous. If a severe recession hits, it has the potential to destroy the entire financial system. Governments will have to take over nearly all the banks, and many big corporations. Social unrest will demand that stockholders be wiped out next time. We are in a different environment than has ever existed because of the crushing amount of debt that governments have created. That debt, when combined with the rising cost of oil, could lead to unprecedented difficulties for the entire world economy in the not too distant future.

So what if the market is overvalued or undervalued, or when exactly Europe implodes? Market psychology is the real enemy in this market and I believe continuing to invest in excellent companies with low debt, reasonable dividends, low betas, and in defensive industries is the way to go now.

rel77 – you may say you are new to investing but I think what you say makes sense, especially this part “I'm also looking very long term, like 10 to 20 years. But most importantly, I'm not betting more than I can afford to lose.” As to which metrics to use, ROIC and PE are just the beginning – keep reading at Fool.com for more, such as PEG, price to free cash flow, price to book, ROE, insider ownership, etc. – you will get a feel for what to look for in which industries and at what stage the company is at in its growth.

mdalcant – yes, I agree – data can be tweaked in just about any direction, but give the author a break – he was not doing a research study here, but an article, after all, and it did get us thinking, for one, and for another, went back further in time more than 10 years, so I say it is an improvement on Schiller’s ideas

LoudJamie – the author gave us four companies in five industries that met his assumptions, which would not be likely to include banks that are on the brink of destruction and “beaten to death that’s at low levels and long term will survive.” He said “expected to grow earnings by at least 15% over the next year” and who can say that about most banks at the moment?

My take on should I or shouldn't I buy stocks now is not very technical to say the least but here it is. I figure things will go one of 2 ways. 1. the worlds financial markets crash leading to world turmoil. 2. The market is being ruled by fear presently and now is the time to buy - yes, this is a DIP! I believe now is the time to buy stocks -you could have grabbed PEP for 59 and change a few days ago or EPD at 38 and change - these are good numbers for these companies. I go with #2 and am looking for just the right buy and there is a hech of a lot to choose from as every other day there is a dip. Up down Up down - it can drive you nuts unless you stay calm and look at the long run. Good luck to us all.

Yes, stocks are "cheap" as in, lower in cost today than they were in June. That doesn't make purchasing today a particularly smart move.

I am currently being very cautious. This is an interesting time. I also agree that fear is in control.

What about inflation, will it happen? Of course it will. The problem is knowing "when." Looking forward at a personal possible timeline of 30 years, it's most likely there will be inflation. The pressures of growing economies in the developing world and shifting wealth will create some interesting and unpleasant outcomes.

There is also no doubt that at some point in the future some stocks will be up as in, selling for greater value than they are today. Others will be selling for less. I'm using inflation adjusted dollars when I make this statement.

My guess for the immediate future? The most likely scenario is a few more years of this. How many? Well, how long will it take for Europe to get its act together? How long for the US to address core unemployment and deficits linked to rising entitlements and the "health care bubble?" How long to pay down all of the debt of the past decade, both personal and that of western governments? Will unemployment gradually ease and return to something below a true 8% or not, and if so, when?

If you know the answer to these questions, then you do know how the broader market will perform.

Finally, when I read some of these articles, I am sometimes concerned. It's intellectually dishonest to pick some information to support a thesis and to ignore that which does not. I realize articles fall into the category of "what if" or "consider this." But using this article as an example, the title is "Stocks Are a Good Investment Now; Here's Why." With the data available and as some comments have noted, it could also be argued that "stocks are a lousy investment now."

Final comment. It's because of positional arguments that the "lost decade" in stocks occurred. There are a lot of people who parrot "stocks are good now, or for the long term" and so on. It ain't necessarily so. The arguments seems to depend upon the entry and exit points.

Brian: Then how can we call a stock cheap if it's earnings are going to fall drastically? For instance:

Micron PE= 7.0 PEG= 0.67 Next years growth rate=81%

However, with a PEG of .67 and a PE of 7 NU's long term average growth rate is 10.44%. Is all that growth coming in the following year with no growth left thereafter?

Weyerhaeuser PE= 7.9 PEG=0.88 Next years growth rate=117%. However the anticipated long term growth rate with PE of 7 and a EG of .88 is 7.95%. If it grows 117% next year what is left for the future with an average yearly growth rate of 7.95%

I look at your numbers and see confusion. I submit that Weyerhaeuser will not have a yearly long term growth rate of 7.95% ( as indicated by your statement of its PE and PEG) AND grow 117% next year. Do you?

I find it hard to believe that Micron will have a long term growth rate of 10.5% +/- ( as indicated by its reported PE and PEG and still grow 81% next year.

If you want to check the numbers, I encourage you to check out the site I used for this article, www.finviz.com. If you notice screaming irregularities, let me know. We already had a commenter above talk about the Micron numbers.

I also encourage you to take a look at the bigger point of the article, which is simply that our market is now undervalued compared to historical (since '65) means.

350 million Europeans and 350 million Northamericans have been the basis of most analyst's thinking in the past.-- Now the world of investing in stocks and bonds is very much larger and I doubt that the maxims and rules that were based on the past are valid today. That's why I go strickly by trends. Unless a stock is going up it's not one I choose, and if it goes down. I get out,-- Who knows what some Chinese or Indian trader is playing. Most likely they have figured out what the Western traders would think and they can game them. HUMMELHUMMEL

So you can't defend these numbers either. It is hard to "look at the bigger point of the article" when the numbers upon which it is based are flawed. They, either, literally don't add up, or suggest outsized gains in one year compared to the long term yearly average. (save for FSLR)

The "bigger point" of the article is that the market is undervalued. This is based, in part, on

Micron with a PE of 7.0 and a PEG of 0.67which implies a 10.44% long term yearly growth rate average BUT will grow THIS YEAR at 81%. (What is the catalyst for such outsized one year growth?)

The long term average growth rate is incorrect, the PEG is incorrect or the exected one year growth rate is incorrect. The bigger point of the article is that SOMETHING is incorrect.

You, Brian, used these numbers in YOUR article. Either defend them or disavow them

EPS before the most recent earnings announcement, which was less than a week before the story was submitted, was $0.61, and the P/E was roughly correct at the time.

However, the numbers weren't yet updated. As of the past week, the company's EPS are $0.15. Expected EPS in FY 2012 are $0.21 (some of this is factored into expected growth over the next 12 months at time of publication, but not all). Expected EPS for FY2013 are $0.60, which explains the high expected growth rate. However, in FY2014, EPS are expected to come in at $0.61, explaining the leveling off.

1) An article about market valuation should mention that credible sources (ECRI in particular) are forecasting an impending recession in the U.S. (much less the rest of the world). Will stocks go up from here or down from here when we enter a recession in the next quarter or perhaps two? Down of course.

2) Take a look at the accumulation of household and sovereign debt in the United States, and specifically when it occurred. Run a correlation between debt accumulation and stock market multiples and profitability. This is an economy that is 70% based on consumption, and so it only makes sense that the more debt that people (and the government) take on, the more sales and profitability companies will have. HOWEVER we are currently in a debt deleveraging phase and likely will be for the rest of this decade and beyond. Even the government is delevering (fiscal contraction). If you restrict your historical PE ratio analysis to the 1960s and forward, I would submit that you are biasing the data heavily towards the one time period where the U.S. significantly ramped up its debt. So in my opinion that's going to give you biased results (too high of an average PE ratio), unless you think that the next 50 years will have a similar debt accumulation.